You may not think of Ukraine as a country with great potential for oil & gas exploration, especially in light of the yearly reports of Russia threatening to cut off supply to Ukraine because of its gas debts. These disputes cause some panic in Ukraine and more in Europe.
In fact, Ukraine only buys gas from Russia for domestic industrial use and not for the supply of gas to the average Ukrainian consumer. Behind the disputes is the fact that Ukraine transports gas to Europe and Russia is interested in obtaining control over the gas supply pipelines.
My colleagues in our Kyiv office tell me that, in the 1950s, the Soviet Union considered that the reserves in oil & gas in Ukraine were sufficient to supply the whole of the Soviet Union. Ukraine has deposits of gas in western Ukraine, in the Carpathian Mountains (where a new discovery was made just a month ago), and both oil&gas deposits in central eastern Ukraine, in the Donetsk region, in Crimea and offshore in both the Sea of Azov and Black Sea.
Some studies have indicated that the Black Sea reserves in deep waters, if tapped into properly, could, on their own, provide Ukraine with about a third of its overall needs. The deep waters of the Black Sea are relatively virgin territory – there has so far been only one attempt to drill in deep water, near Turkey.
In the last 16 years since Ukraine’s independence, there has been some exploration and production by foreign companies – since only Ukrainian companies can hold licences, this must be done indirectly by setting up a joint venture or by doing deals with existing licence holders. Recently, the big players have become interested in Ukraine as well; however, there are a number of stumbling blocks.
One of the biggest stumbling blocks is the licensing procedure. In 2004, the provisions of the oil & gas law on issuing licences were suspended and there was a moratorium on the issue of licences that, in theory, extended until the end of the year. Regardless of the legislation, more than 800 licences were issued prior to the Orange Revolution in 2004. In 2005, the moratorium continued and some of the licences issued in 2004 were challenged in the courts and annulled, but there was a lack of any consistent policy.
In 2006, the cabinet of ministers issued a new resolution on the issue of licences for that year. Since then, each year there has been a similar new resolution of the cabinet of ministers, and these vary from year to year. Moreover, these resolutions do not appear until March or April, thus no licences can be issued before that time.
This instability naturally leaves investors and foreign oil & gas companies uneasy – if their licences need to be renewed next year (2009), there is no guarantee what type of procedure will be in place by then. As you might expect, there has been considerable lobbying from many interested parties, and the big players continue to press home this point. It remains to be seen whether the Ukrainian government will take note.
Meanwhile, last month in the Russian Federation, a new federal law on foreign investment in strategic industries (the Strategic Industries Law) came into force, which demonstrates the increasing degree of control imposed by the Russian state over its natural resources.
The Strategic Industries Law requires a foreign investor to obtain government consent for making investment into a company that operates in an industry connected with state security and defence. The list of industries that are deemed to be of strategic importance covers 42 categories, including “geological study and/or exploration and extraction of minerals on subsoil areas of federal significance”.
At the same time, significant amendments were introduced into the Federal Subsoil Law that sets out the general framework for exploration and production activities in Russia. The definition of a “subsoil area of federal significance” is found in the amendments to the subsoil law. All subsoil areas of inland seas, territorial seas and the continental shelf of the Russian Federation are considered to be of federal significance.
“Areas of federal significance” also include the onshore areas with reserves of more than 70million tonnes of oil or 50billion cu m of gas, as well as those whose development involves using land plots allocated for state security and defence purposes. The list of areas of federal significance is to be officially published.
Companies holding licences for geological study and/or exploration and production in areas of federal significance are regarded as companies with strategic importance for the Russian Federation. Any foreign investor that intends to acquire “control” over such a strategic company must obtain prior consent of the governmental commission for control over foreign investment in the Russian Federation.
The Strategic Industries Law sets out an extensive definition of “control” – this includes some contractual arrangements and even acquisition of a stake of as little as 10% in a strategic company. If a foreign investor is controlled by a foreign state or international organisation, it needs consent even for a 5% stake and such investors are not allowed to acquire 10% or more of the shares or otherwise establish control over a strategic company.
The provisions of the Strategic Industries Law also apply to acquisition of shares in a non-Russian company if, as a result of the transaction, the purchaser will acquire control over a strategic company in Russia.
Companies where the Russian Federation holds, directly or indirectly, more than 50% of voting shares are exempted from all requirements of the Strategic Industries Law (other than the requirement to seek a government consent if an investor controlled by a foreign state or international organisation intends to acquire more than 5% interest in a strategic company). National oil & gas giants Rosneft and Gazprom and their subsidiaries therefore benefit from a preferential regime that will enable them to continue to attract foreign investment.
New E & P licences for areas of federal significance can only be granted by the government of the Russian Federation and not by the regions. If, as a result of exploration activities under a regular licence, a company makes a discovery that meets the criteria of an area of federal significance, the government has the right to terminate the licence. The procedure for calculation and payment of compensation to be paid to the company in these circumstances is not yet enacted.
The amendments to the Subsoil Law also impose special requirements in respect of companies to be involved in exploration and development of offshore deposits.
An offshore licence can only be granted to a Russian company that has at least five years’ experience of development on the Russian continental shelf and where the Russian Federation directly or indirectly holds 50% of voting shares.
It is clear that any company wanting to do business in Ukraine or Russia has to understand the local legal regime and its risks, but opportunities remain, especially for service companies willing to work with local operators.
Kyiv, in Ukraine, is the site of the latest CMS Cameron McKenna office – if you would like an introduction to our local energy teams there or in Moscow, please get in touch with me.
Penelope Warne is head of energy at CMS Cameron McKenna LLP